People avoid actions that create regret and seek actions that cause

Transcription

1 M03_NOFS2340_03_SE_C03.QXD 6/12/07 7:13 PM Page 22 CHAPTER 3 PRIDE AND REGRET Q People avoid actions that create regret and seek actions that cause pride. Regret is the emotional pain that comes with realizing that a previous decision turned out to be a bad one. Pride is the emotional joy of realizing that a decision turned out well. Consider this state lottery example. 1 You have been selecting the same lottery ticket numbers every week for months. Not surprisingly, you have not won. A friend suggests a different set of numbers. Do you change numbers? Clearly, the likelihood of the old set of numbers winning is the same as the likelihood of the new set of numbers winning. This example has two possible sources of regret. Regret will result if you stick with the old numbers and the new numbers win. This is called the regret of omission (not taking an action). Regret also will result if you switch to the new numbers and the old numbers win. The regret of an action you took is the regret of commission. In which case would the pain of regret be stronger? The stronger regret would most likely result from switching to the new numbers because you have a lot of emotional capital in the old numbers after all, you have been selecting them for months. A regret of commission generally is more painful than a regret of omission. Investors often regret the actions they take, but rarely regret the ones they do not. DISPOSITION EFFECT Avoiding regret and seeking pride affects people s behavior, but how does it affect investment decisions? Two financial economists, Hersh Shefrin and Meir Statman, adapted this psychological behavior to the investor. 2 They show that fearing regret and seeking pride causes investors to be predisposed to selling winners too early and riding losers too long. They call this the disposition effect. Consider the situation in which you wish to invest in a particular stock. However, you have no cash and must sell a position in another stock in order to have the cash for the new purchase. You can sell either of two stocks you hold. Stock A has earned a 20 percent return since you purchased it, whereas stock B has lost 20 percent.which stock do you sell? Selling stock A validates

2 M03_NOFS2340_03_SE_C03.QXD 6/12/07 7:13 PM Page 23 CHAPTER 3 Pride and Regret 23 your good decision to purchase it in the first place. It would make you feel proud to lock in your profit. Selling stock B at a loss means realizing that your decision to purchase it was bad. You would feel the pain of regret. The disposition effect predicts that you will sell the winner, stock A. Selling stock A triggers the feeling of pride and allows you to avoid regret. DISPOSITION EFFECT AND WEALTH Why is it a problem that investors may sell their winners more frequently than their losers? One reason relates to the U.S. tax code. The taxation of capital gains causes the selling of losers to be the wealth-maximizing strategy. Selling a winner leads to the realization of a capital gain and hence payment of taxes. Those taxes reduce your profit. On the other hand, selling the losers gives you a chance to reduce your taxes, thus decreasing the amount of the loss. Reconsider the previously mentioned example and assume that capital gains are taxed at the 15 percent rate (Table 3.1). If your positions in stocks A and B are each valued at $1,000, then the original purchase price of stock A must have been $833, and the purchase price of stock B must have been $1,250. If you sell stock A, you receive $1,000 but pay taxes of $26.55, so your net proceeds are $ Alternatively, you could sell stock B and receive $1,000 plus gain a tax credit of $37.50 to be used against other capital gains, so your net proceeds are $1, If the tax rate is higher than 15 percent (as in the case of gains realized within one year of the stock purchase), then the advantage of selling the loser is even greater. Interestingly, the disposition effect predicts the selling of winners even though selling the losers is the wealth-maximizing strategy. TESTS OF AVOIDING REGRET AND SEEKING PRIDE Do investors behave in a rational manner by predominantly selling losers, or are investors affected by their psychology and have a tendency to sell their winners? Several studies provide evidence that investors behave in a TABLE 3.1 Capital Gains and Taxation Sell Stock A Stock B Sale Proceeds $1,000 $1,000 Tax Basis $833 $1,250 Taxable Gain (Loss) $177 ($250) Tax (Credit) at 15 Percent $26.55 ($37.50) After-Tax Proceeds $ $1,037.50

3 M03_NOFS2340_03_SE_C03.QXD 6/12/07 7:13 PM Page CHAPTER 3 Pride and Regret manner more consistent with the disposition effect (selling winners). These studies generally fall into two categories: studies that examine the stock market and those that examine investor trades. For example, Stephan Ferris, Robert Haugen, and Anil Makhija 3 examined the trading volume of stocks following price changes. If investors trade to maximize wealth, then they should sell stocks with price declines and capture the tax benefits. In addition, they should refrain from selling stocks with price gains to avoid paying taxes. Therefore, the volume of trades should be high for stocks with losses and low for stocks with gains. Alternatively, investors may opt to avoid regret and seek pride. In this case, it would be expected that investors will hold their losers and sell their winners. Therefore, high volume in the stocks with gains and low volume in the stocks with declines is consistent with the disposition effect. Ferris et al., used a methodology that determines the normal level of volume expected for each stock. They reported results that can be interpreted as a form of abnormal volume; that is, a negative abnormal volume indicates less trading than normal, whereas a positive abnormal volume indicates more trading than normal. Using the 30 smallest stocks on the New York Stock Exchange (NYSE) and the American Stock Exchange during December 1981 to January 1985, they grouped each stock into categories based on the percentage gain or loss at each point in time. The results are presented in Figure 3.1. Note that the stocks with losses of more than 22.5 percent are grouped in the left column.the loss diminishes in each column to the right until the middle of the graph, where stocks had small losses or gains. Stocks in the far-right column had a gain of more than 22.5 percent. In general, stocks with gains had positive abnormal volume, whereas stocks with declines had negative abnormal volume. Higher volume in stocks with gains and lower volume in stocks with declines is consistent with the disposition effect. FIGURE 3.1 Volume of Stocks After Losses and Gains Abnormal Volume (percent) Dec Jan Nov 0.8 < 22.5% 22.5% 15% to 7.5% 0% to 7.5% to 15% 7.5% to 0% 7.5% to 15% Stock s Gain During the Year 15% to 22.5% >22.5%

4 M03_NOFS2340_03_SE_C03.QXD 6/12/07 7:13 PM Page 25 CHAPTER 3 Pride and Regret 25 This analysis was performed separately for volume in December and the rest of the year because people are more aware of the benefits of selling losers and gaining tax advantages in December. Therefore, it would seem that investors might be more likely to enact a wealth-maximizing strategy in December versus the other months. However, Figure 3.1 shows that investors avoid regret and seek pride as much in December as during the rest of the year. Other studies have analyzed the actual trades and portfolios of individual investors. In an older study using trades from a national brokerage house during 1964 to 1970, Schlarbaum et al. examined 75,000 round-trip trades. 4 A round-trip trade is a stock purchase followed later by the sale of the stock. They examined the length of time the stock was held and the return that was received. Are investors quick to close out a position when it has taken a loss or when it has a gain? Consider the behavior implied by the disposition effect. If you buy a stock that goes up quickly, you will be more inclined to sell it quickly. If you buy a stock that goes down or remains level, you are more inclined to hold while waiting for it to go up. Therefore, stocks held for a short time tend to be winners, and stocks held longer are likely to be less successful. Figure 3.2 shows the average annualized return for a position held for less than 1 month, 1 to 6 months, 6 to 12 months, and more than 1 year. The figure indicates that investors are quick to realize their gains. The average annualized return for stocks purchased then sold within 1 month was 45 percent. The returns for stocks held 1 to 6 months, 6 to 12 months, and more than 1 year were 7.8 percent, 5.1 percent, and 4.5 percent, respectively. It appears that investors are quick to sell winners. Using a more recent sample, Terrance Odean studied the trades of 10,000 trading accounts from a nationwide discount brokerage during FIGURE 3.2 Annualized Return for Different Investor Holding Periods Annualized Return to to to 365 >365 Holding Period (Days)

5 M03_NOFS2340_03_SE_C03.QXD 6/12/07 7:13 PM Page CHAPTER 3 Pride and Regret 1987 to At each sell trade, Odean calculated the amount of gains and losses the investor had on paper in his or her portfolio. If the investor sold a winner, then he calculated the gain on the stock and divided by the total paper gains available to the investor. The result is the proportion of total gains that the investor realized with the sell trade. If the stock sold was a loser, then the proportion of total losses realized was computed. Odean found that when investors sell winners, the sale represents 23 percent of the total gains of the investor s portfolio. Alternatively, when a loser is sold, it represents only 15.5 percent of the unrealized losses in the portfolio. On average, investors are 50 percent more likely to sell a winner than a loser. INTERNATIONAL TESTS OF THE DISPOSITION EFFECT Researchers have found the disposition effect to be pervasive. Investors in Finland, Israel, and China exhibit the behavior. Grinblatt and Matti Keloharju studied all investor trades in Finland during 1995 and They found that a large positive return the previous week significantly increases an investor s propensity to sell the stock. On the other hand, a large decrease in price significantly increases the probability that the investor will hold the stock. They also found that the more recently the stock gains or losses occurred (last week versus last month), the stronger the propensity was to sell winners and hold losers. For investors in Israel, Zur Shapira and Itzhak Venezia find that individual investors hold on to winner stocks for an average of 20 days and loser stocks for 43 days. 7 Investors hold losers twice as long as winners! Chinese investors also realize more gains than losses and hold losers 10 days longer than winners. 8 SELLING WINNERS TOO SOON AND HOLDING LOSERS TOO LONG The disposition effect not only predicts the selling of winners but also suggests that the winners are sold too soon and the losers are held too long. What does selling too soon or holding too long imply for investors? Selling winners too soon suggests that those stocks will continue to perform well after they are sold. Holding losers too long suggests that those stocks with price declines will continue to perform poorly. When an investor sold a winning stock, Odean found that the stock generally beat the market during the next year by an average 2.35 percent. 9 During this same year, the loser stocks that the investors kept generally underperformed the market by 1.06 percent. Investors tend to sell the stock that ends up providing a high return and keep the stock that provides a low return. Note that the fear of regret and the seeking of pride hurt investors wealth in two ways. First, investors are paying more in taxes because of the

6 M03_NOFS2340_03_SE_C03.QXD 6/12/07 7:13 PM Page 27 CHAPTER 3 Pride and Regret 27 disposition to sell winners instead of losers. Second, investors earn a lower return on their portfolio because they sell the winners too early and hold poorly performing stocks that continue to perform poorly. Martin Weber and Colin Camerer designed a stock trading experiment for their students. 10 They create six stocks for trading and show the students the last three price points of each stock. They designed the experiment so that the stock prices are likely to trend; that is, stocks with gains will likely continue to gain, whereas stocks with declines will likely continue to decline. The students are shown the potential prices for each stock in the future. Because of this experimental design, stocks with losses should be sold and stocks with gains should be held (the opposite of the disposition effect). Contrary to the wealth-maximizing strategy, the subjects sold fewer shares when the price was below the purchase price than when the price was above, thus exhibiting the disposition effect. DISPOSITION EFFECT AND NEWS One study investigated all the trades of individual investors in 144 NYSE firms during the November 1990 through January 1991 period. 11 Specifically, how investors react to news about the company and news about the economy was studied. News about a company primarily affects the price of the company s stock, whereas economic news affects all firms. Good news about a firm that increases the stock price induces investors to sell (selling winners). Bad news about a firm does not induce investors to sell (holding losers).this is consistent with avoiding regret and seeking pride. However, news about the economy does not induce investor trading. Although good economic news increases stock prices and bad economic news lowers stock prices, this does not cause individual investors to sell. In fact, investors are less likely than usual to sell winners after good economic news. These results are not consistent with the disposition effect. This illustrates an interesting characteristic of regret. When taking a stock loss, investors feel stronger regret if the loss can be tied to their own decision. However, if investors can attribute the loss to reasons that are out of their control, then the feeling of regret is weaker. 12 For example, if the stock you hold declines in price when the stock market itself is advancing, then you have made a bad choice, and regret is strong. However, if the stock you hold declines in price during a general market decline, then this is essentially out of your control, so the feeling of regret is weak. Investor actions are consistent with the disposition effect for company news because the feeling of regret is strong. In the case of economic news, investors have a weaker feeling of regret because the outcome is considered beyond their control. This leads to actions that are not consistent with the predictions of the disposition effect.

7 M03_NOFS2340_03_SE_C03.QXD 6/12/07 7:13 PM Page CHAPTER 3 Pride and Regret REFERENCE POINTS The pleasure of achieving gains and the pain of losses is a powerful motivator of human behavior. However, it might be difficult to determine whether some investment transactions are considered a profit or a loss. For example, Bob purchases a stock for $50 per share. At the end of the year, the stock is trading for $100.Also at the end of the year, Bob reexamines his investment positions in order to record and determine his net worth and monitor the progress he has made toward his financial goals. Six months later, Bob sells the stock for $75 per share. He has made a profit of $25 per share. However, the profit is $25 per share lower than if he had sold at the end-of-year price. Clearly he made a $25-per-share profit. However, does Bob feel like he made a profit, or does he feel like he lost money? This issue deals with a reference point. A reference point is the stock price that we compare with the current stock price. The current stock price is $75. Is the reference point the purchase price of $50 or the end-of-year price of $100? The brain s choice of a reference point is important because it determines whether we feel the pleasure of obtaining a profit or the pain of a loss. The early investigations into the psychology of investors assumed that the purchase price was the reference point. However, investors monitor and remember their investment performance over the period of a year. 13 If the purchase was made long ago, then investors tend to use a more recently determined reference point. What recent stock price is used as a reference? Possible recent references are the mean or median price of the past year. Additionally, the 52-week high and low prices are commonly reported in the media. Recent research suggests that investors use the 52-week maximum as the reference point. An interesting investigation of the exercising of stock options illustrates the reference point. 14 Some managerial corporate employees receive stock options as part of their compensation. These options are frequently structured so that the strike price is equal to the price of the stock at the time the options are issued. The employee cannot exercise the options for a period of several years (the vesting period). Afterward, the employee can exercise the options and receive the difference between the stock price at the time and the strike price of the option. Studying the employee option exercise has several advantages. First, employees who receive options as compensation are usually more sophisticated employees. Second, these options usually have a maturity date, and the employee knows that the options must be exercised before they expire. This feature helps mitigate any status quo bias. Third, a clear reference point does not exist. The options themselves have no price. The option strike price is an important reference because the stock price must be above the strike for any profit to be achieved. However, if the stock

8 M03_NOFS2340_03_SE_C03.QXD 6/12/07 7:13 PM Page 29 CHAPTER 3 Pride and Regret 29 price is above the strike price after the vesting period, what reference point does the employee use? It appears that the most likely reference point used is the highest price of the previous year. Using detailed records for 50,000 employees at seven corporations, Chip Heath, Steven Huddart, and Mark Lang found that the rate of exercising options nearly doubles when the stock price moves above the 52-week high. Consider the employees who want to exercise some options. The current stock price is lower than the 52-week high. Using this yearly high as a reference, the employees consider their position to be at a loss. Wanting to avoid regret, the employees wait until the stock price moves higher again so they can break even. When the stock price meets or exceeds the 52-week high, the employees are much more likely to exercise the options because they believe the stock has exceeded the reference point. The researchers showed that the rate of option exercise increases when the stock price crosses a historical maximum. In the investor s mind, the reference point determines whether a position is at a profit or loss. However, it appears that investors periodically update the reference point to reflect unrealized profits. Returning to the example at the beginning of this section, Bob probably feels like he lost money because he moved his reference point to $100 when he recorded that price in his end-of-year evaluation. CAN THE DISPOSITION EFFECT IMPACT THE MARKET? Can the presence of a large group of investors suffering from the disposition effect impact market prices? Andrea Frazzini provides evidence that it does. 15 Consider a stock that has risen in price and has many investors who hold capital gains in it. If this firm announces good news (like a great earnings report), the selling of this winner will temporarily depress the stock price from fully rising to its deserved new level. From this lower price base, subsequent returns will be higher. This price pattern is known as an underreaction to news and a postannouncement price drift. Frazzini shows that the postannouncement drift occurs primarily in winner stocks where investors have unrealized capital gains and loser stocks with unrealized capital losses. Frazzini first analyzes mutual fund holding data and finds that they also display the disposition effect. In fact, the funds that performed the worst were the most reluctant to close their losing positions. To estimate the amount of unrealized capital gains (or losses) in each stock, an average cost basis of the mutual funds is computed. This basis is used as the reference point in comparison to current prices. Stocks with current prices higher than the reference point are considered winner stocks with unrealized capital gains by many investors. The largest positive postannouncement drift occurs for stocks with good news and large unrealized capital

9 M03_NOFS2340_03_SE_C03.QXD 6/12/07 7:13 PM Page CHAPTER 3 Pride and Regret gains. The largest negative drift occurs for stocks with bad news and large unrealized capital losses. This pattern is consistent with disposition investors quickly selling winners, preventing the stock price from initially rising to its new level. Disposition investors are also reluctant to sell losers, thus underreacting to negative news about these firms. To summarize this chapter, people act (or fail to act) to avoid regret and seek pride, which causes investors to sell their winners too soon and hold their losers too long. This behavior hurts investor wealth in two ways. First, investors pay more capital gains taxes because they sell winners. Second, investors earn a lower return because the winners they sell and no longer have continue to perform well, while the losers they still hold continue to perform poorly. Questions 1. Consider an investor s statement: If the stock price would only get back up to what I paid for it, I d sell it! Describe how the biases in this chapter are influencing the investor s decision. 2. How would the number of stocks held in the portfolio impact the disposition effect? 3. How can succumbing to the disposition effect harm wealth? 4. How can the disposition effect impact market prices? Endnotes 1. This example is adapted from Roger G. Clarke, Stock Krase, and Meir Statman, Tracking Errors, Regret, and Tactical Asset Allocation, Journal of Portfolio Management 20(1994): Hersh Shefrin and Meir Statman, The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence, Journal of Finance 40(1985): Stephen P. Ferris, Robert A. Haugen, Anil K. Makhija, Predicting Contemporary Volume with Historic Volume at Differential Price Levels: Evidence Supporting the Disposition Effect, Journal of Finance 43(1987): Gary G. Schlarbaum, Wilbur G. Lewellen, and Ronald C. Lease, Realized Returns on Common Stock Investments: The Experience of Individual Investors, Journal of Business 51(1978): Terrance Odean, Are Investors Reluctant to Realize Their Losses?, Journal of Finance 53(1998): Mark Grinblatt and Matti Keloharju, What Makes Investors Trade?, Journal of Finance 56(2001): Zur Shapira and Itzhak Venezia, Patterns of Behavior of Professionally Managed and Independent Investors, Journal of Banking and Finance 25(2001): Gongmeng Chen, Kenneth Kim, John Nofsinger, and Oliver Rui, Trading Performance, Disposition Effect, Overconfidence, Representativeness Bias, and Experience of Emerging Market Investors, Journal of Behavioral Decision Making, forthcoming, 2007.

10 M03_NOFS2340_03_SE_C03.QXD 6/12/07 7:13 PM Page 31 CHAPTER 3 Pride and Regret Actually, Odean calculates an abnormal return that is based not on the market but rather on matching firms. 10. Martin Weber and Colin F. Camerer, The Disposition Effect in Securities Trading: An Experimental Analysis, Journal of Economic Behavior and Organization 33(1998): John R. Nofsinger, The Impact of Public Information on Investors, Journal of Banking and Finance 25(2001): This discussion is adapted from Roger G. Clarke, Stock Krase, and Meir Statman, Tracking Errors, Regret, and Tactical Asset Allocation, Journal of Portfolio Management 20(1994): Shlomo Benartzi and Richard Thaler, Myopic Loss-Aversion and the Equity Premium Puzzle, Quarterly Journal of Economics 110(1995): This discussion derives from Chip Heath, Steven Huddart, and Mark Lang, Psychological Factors and Stock Option Exercise, Quarterly Journal of Economics 114(1999): Andrea Frazzini, The Disposition Effect and Underreaction to News, Journal of Finance 61(2006):